Financial Instruments under Ind AS — Practice

Question 1

A company issues preference shares labelled as 'equity shares — Class B' in its constitutional documents, but the shares carry a mandatory redemption at a fixed date five years from issue, requiring the company to redeem them for cash regardless of its own preference. Determine whether these instruments are classified as a financial liability or equity under Ind AS 32, and explain why the label used is not determinative.

Accepted Answer

These instruments are classified as a financial liability, not equity, despite being labelled 'equity shares.' Ind AS 32 requires classification based on the substance of the contractual arrangement, not its legal form or the label given to it, and the core test is whether the instrument contains a contractual obligation for the issuer to deliver cash or another financial asset to another party. Because the company has a mandatory obligation to redeem these shares for cash on a fixed date, regardless of its own preference or discretion, a genuine contractual obligation to deliver cash exists, satisfying the definition of a financial liability; the fact that the issuer's own documents call the instrument an 'equity share' has no bearing on this classification, since Ind AS 32's entire purpose in this area is to prevent instruments carrying substantively debt-like, mandatory cash-delivery obligations from being dressed up as equity through favourable labelling, which would otherwise materially understate a company's genuine leverage and financial risk as reported in its balance sheet.

Question 2

A company issues a convertible bond for ₹100 lakh, convertible into a fixed number of equity shares at the holder's option. A similar bond with no conversion feature would have a fair value of ₹92 lakh. Compute the liability and equity components at issuance, and explain why the equity component is never subsequently remeasured.

Accepted Answer

The liability component is measured first, at the fair value of a similar instrument with no conversion feature, ₹92 lakh. The equity component is the residual: total proceeds ₹100 lakh − liability component ₹92 lakh = ₹8 lakh, recognised within equity. The equity component is never subsequently remeasured because it represents a fixed contractual right, the option to convert into a fixed number of shares in exchange for extinguishing a fixed amount of debt, satisfying what is often called the 'fixed for fixed' condition that characterises a genuine equity instrument under Ind AS 32; since this conversion right does not itself constitute a further contractual obligation to deliver cash or another financial asset (the holder, not the issuer, controls whether conversion occurs, and if it does, the issuer delivers a fixed number of its own shares, not cash), it is treated as equity from the outset and, consistent with equity's general treatment throughout Ind AS, its value is not revisited or remeasured in subsequent periods regardless of how the bond's own market value or the underlying share price subsequently moves.

Question 3

A bank holds a portfolio of corporate bonds with a business model of collecting contractual cash flows and also selling bonds opportunistically to manage liquidity, and the bonds' contractual terms provide for fixed periodic interest and repayment of principal at maturity, with no other cash flow features. Classify this financial asset under Ind AS 109 and explain your reasoning.

Accepted Answer

This financial asset should be classified as measured at fair value through other comprehensive income (FVOCI). Applying the business model test, the portfolio is held both to collect contractual cash flows and to sell bonds opportunistically, which is precisely the 'collect and sell' business model Ind AS 109 associates with FVOCI classification, distinct from a 'hold to collect' business model (which would point to amortised cost) or a business model focused on trading for short-term profit (which would point to FVTPL). Applying the SPPI test, the bonds' contractual terms provide only for fixed periodic interest and repayment of principal at maturity, with no other embedded cash flow features such as conversion options or variable, non-interest-linked payments, which satisfies the requirement that contractual cash flows are solely payments of principal and interest on the principal amount outstanding. Since both the business model test (collect and sell) and the SPPI test are satisfied, the bonds are measured at FVOCI, with interest income, impairment and foreign exchange gains/losses recognised in profit or loss as they would be under amortised cost, but with other fair value movements recognised in OCI and recycled to profit or loss upon derecognition of the bonds.

Question 4

A company holds a small strategic equity investment in an unlisted company, not held for trading, and elects at initial recognition to present fair value changes in OCI. Two years later, the investment is sold at a substantial gain over its most recent fair value. Explain where this gain is recognised, and why this differs from the treatment of a debt instrument held at FVOCI.

Accepted Answer

For an equity investment where the entity has made the irrevocable FVOCI election at initial recognition, all fair value gains and losses, including any further gain or loss realised on eventual disposal, are recognised in other comprehensive income and are never subsequently reclassified (recycled) to profit or loss, even upon disposal of the investment; the cumulative gain accumulated in OCI over the holding period may be transferred within equity, for instance to retained earnings, but never through profit or loss. This differs distinctly from a debt instrument held at FVOCI, where fair value movements are also recognised in OCI during the holding period, but are recycled to profit or loss upon derecognition of the instrument, meaning the cumulative gain or loss does eventually pass through profit or loss when the debt instrument is sold or matures. This asymmetry between debt-instrument FVOCI (recycled) and equity-instrument FVOCI (never recycled) is a deliberate, distinguishing design feature of Ind AS 109, intended specifically to prevent the equity FVOCI election from being used as a vehicle for selectively timing when gains are recognised in profit or loss, since the election permanently keeps all such gains and losses out of profit or loss entirely.

Question 5

A bank originates a loan and initially assesses it as Stage 1, recognising a 12-month ECL of ₹2 lakh. One year later, the borrower's credit rating has significantly deteriorated, though no default has yet occurred, and the bank reassesses the loan as Stage 2, computing lifetime ECL of ₹9 lakh. Explain why the loss allowance increases from ₹2 lakh to ₹9 lakh, and what would trigger a further move to Stage 3.

Accepted Answer

The loss allowance increases from a 12-month ECL of ₹2 lakh to a lifetime ECL of ₹9 lakh because the loan's classification has moved from Stage 1, where there has been no significant increase in credit risk since initial recognition and only expected losses from default events possible within the next 12 months are provided for, to Stage 2, where a significant increase in credit risk since initial recognition, evidenced here by the significant deterioration in the borrower's credit rating, requires the full lifetime expected credit losses, from all possible default events over the loan's entire expected remaining life, to be recognised, not merely losses expected within the next 12 months; this substantial widening of the loss horizon, from 12 months to the loan's full remaining life, is precisely what drives the loss allowance from ₹2 lakh to ₹9 lakh, reflecting the forward-looking, expected-loss philosophy underlying Ind AS 109's impairment model. A further move to Stage 3 would be triggered by objective evidence that the loan has actually become credit-impaired, such as an actual default, a significant financial difficulty of the borrower, or a breach of contract; at Stage 3, lifetime ECL continues to be recognised (no further increase in the loss horizon beyond Stage 2), but interest revenue is thereafter calculated on the loan's net carrying amount, after deducting the loss allowance, rather than on its gross carrying amount, reflecting that interest income can no longer reasonably be accrued on the full amount once the asset is genuinely credit-impaired.

Question 6

Explain why Ind AS 109 permits a simplified expected credit loss approach for trade receivables without a significant financing component, and how this differs from the general three-stage model.

Accepted Answer

The simplified approach permits an entity to recognise a loss allowance at an amount equal to lifetime expected credit losses from initial recognition of the trade receivable, bypassing the requirement to first assess whether there has been a significant increase in credit risk since initial recognition (the trigger that, under the general model, distinguishes Stage 1 from Stage 2). This simplification is permitted specifically because trade receivables without a significant financing component are typically short-duration, high-volume assets for which tracking a detailed, individually-assessed significant-increase-in-credit-risk indicator for every single receivable would impose a disproportionate administrative burden relative to the benefit, and because a lifetime-ECL approach applied from the outset is already a reasonably conservative, and practically simpler, basis for such short-term assets, where the difference between a 12-month ECL and a lifetime ECL is often small in any case given the receivable's own short expected life. This differs from the general three-stage model, which requires an initial classification into Stage 1 (12-month ECL), and ongoing monitoring for a significant increase in credit risk that would move the asset to Stage 2 or 3 (lifetime ECL), a more operationally intensive, individually tracked assessment appropriate for longer-duration financial assets such as loans and bonds, where the difference between 12-month and lifetime ECL is typically far more material.

Question 7

A company enters a forward contract to hedge the currency risk of a highly probable forecast foreign currency purchase expected to occur in six months, and designates this as a cash flow hedge. At the reporting date, the forward contract has an unrealised gain of ₹6 lakh, all of which is assessed as effective. Explain how this gain should be recognised, and what happens to it when the forecast purchase transaction actually occurs.

Accepted Answer

Under cash flow hedge accounting, the effective portion of the gain or loss on the hedging instrument, here the full ₹6 lakh unrealised gain since it is assessed as entirely effective, is recognised in other comprehensive income and accumulated in a cash flow hedge reserve within equity, rather than being recognised immediately in profit or loss; any ineffective portion, if there were one, would be recognised immediately in profit or loss, but none arises here given full effectiveness. When the forecast foreign currency purchase transaction actually occurs, the accumulated ₹6 lakh in the cash flow hedge reserve is reclassified out of OCI at that point: if the forecast transaction results in the recognition of a non-financial asset or liability (such as inventory purchased in the foreign currency), the accumulated amount is typically removed from OCI and included directly in the initial cost of that asset or liability, a treatment known as a 'basis adjustment'; alternatively, or for hedges of transactions that directly affect profit or loss, the accumulated amount is reclassified from OCI to profit or loss in the same period the hedged forecast transaction itself affects profit or loss, ensuring the gain on the hedge and the effect of the hedged transaction are recognised in the same period, which is precisely the alignment of timing that hedge accounting exists to achieve.

Question 8

Explain the key difference between a fair value hedge and a cash flow hedge in terms of where the effective portion of the hedging instrument's gain or loss is recognised, and why this difference exists.

Accepted Answer

In a fair value hedge, both the hedging instrument's gain or loss and the offsetting change in the fair value of the hedged item (attributable to the hedged risk) are recognised in profit or loss in the same period, so the two effects offset each other directly within profit or loss; this is appropriate because a fair value hedge protects against changes in the fair value of an already-recognised asset, liability or firm commitment, and the hedged item's own fair value change would, or in the case of certain firm commitments, is deemed to, itself be recognised in profit or loss, so recognising the hedging instrument's offsetting gain or loss in the same location achieves the intended offset. In a cash flow hedge, the effective portion of the hedging instrument's gain or loss is instead recognised in other comprehensive income, not profit or loss, because a cash flow hedge protects against variability in future cash flows from a forecast transaction or a recognised item's cash flows, and the hedged transaction itself has generally not yet affected profit or loss at the time the hedge gain or loss arises; recognising the hedge gain or loss in OCI and deferring it until the hedged transaction itself affects profit or loss ensures the two are matched in the same period they should genuinely offset, rather than the hedge gain or loss hitting profit or loss prematurely, before the transaction it is hedging has even occurred.

Question 9

Name the three principal categories of risk Ind AS 107 requires an entity to disclose in relation to its financial instruments, and briefly describe what each concerns.

Accepted Answer

The three principal categories are credit risk, liquidity risk, and market risk. Credit risk is the risk that one party to a financial instrument will fail to discharge an obligation and cause the other party to incur a financial loss, such as the risk a debtor will default on a receivable or loan. Liquidity risk is the risk that an entity will encounter difficulty in meeting obligations associated with its financial liabilities that are settled by delivering cash or another financial asset, essentially the risk of being unable to meet payment obligations as they fall due. Market risk is the risk that the fair value or future cash flows of a financial instrument will fluctuate because of changes in market prices, and is itself further split into currency risk (exposure to exchange rate movements), interest rate risk (exposure to interest rate movements), and other price risk (exposure to changes in market prices other than those arising from interest rate or currency risk, such as equity price risk on an investment portfolio), with Ind AS 107 requiring both qualitative disclosure of how each risk arises and is managed, and quantitative disclosure including sensitivity analysis for market risk exposures.

Question 10

Continuing from the convertible bond example where the liability component was measured at ₹92 lakh at issuance, explain how this liability component is subsequently measured over the life of the bond, and what happens to the discount embedded in it.

Accepted Answer

The liability component, initially recognised at ₹92 lakh, is subsequently measured at amortised cost using the effective interest method, exactly as any other financial liability measured at amortised cost would be. Since ₹92 lakh represents the present value of the bond's contractual cash flows (interest and principal) discounted at a market rate appropriate for a similar bond with no conversion feature, and this is less than the amount that will ultimately need to be paid to bondholders who do not convert, the ₹8 lakh difference (the discount embedded in the liability, separate from the ₹8 lakh equity component computed from total proceeds) is unwound over the bond's life through the effective interest method, increasing the carrying amount of the liability component each period as interest expense is recognised at the market rate, with the cash interest actually paid based on the bond's stated coupon rate; the difference between the effective interest expense recognised and the cash coupon paid increases the liability's carrying amount over time, consistent with how any other amortised-cost liability issued at a discount is subsequently accounted for.

Question 11

A company's treasury division decides to change its business model for a portfolio of debt securities from 'hold to collect' to 'hold to collect and sell,' following a genuine, significant change in how the portfolio is now managed. Explain whether this permits reclassification of the financial assets, and contrast this with a company that merely decides to sell one specific bond from an otherwise unchanged 'hold to collect' portfolio.

Accepted Answer

A genuine change in business model, such as the treasury division's described shift from 'hold to collect' to 'hold to collect and sell,' following a demonstrable, significant change in how the portfolio is actually managed going forward, is precisely the type of event Ind AS 109 requires before reclassification of financial assets is permitted; reclassification is applied prospectively from the reclassification date, with the assets moved from amortised cost to FVOCI classification (or whichever category matches the new business model), and any resulting difference between the previous amortised cost carrying amount and fair value at the reclassification date is recognised in OCI, not retrospectively restated. By contrast, a company that merely decides to sell one specific bond from an otherwise unchanged 'hold to collect' portfolio has not changed its business model at all — it has simply made an individual asset-specific decision, which Ind AS 109 explicitly states does not, on its own, constitute a change in business model; the sale of that one bond may be accounted for as a derecognition event under the existing classification, but it does not trigger or justify reclassifying the remainder of the portfolio, since the business model itself, applied to how the entity manages its financial assets collectively, has not genuinely changed merely because one asset within it was sold.

Question 12

A company renegotiates the terms of an existing loan with its lender, resulting in a change to the loan's cash flows. Explain the two possible accounting outcomes Ind AS 109 provides for such a modification, and the test used to determine which applies.

Accepted Answer

Ind AS 109 requires an entity to test whether a modification of a financial liability's terms is 'substantial,' commonly assessed using a 10% test comparing the present value of the cash flows under the new terms, discounted at the original effective interest rate, against the present value of the remaining cash flows under the original terms; if this difference is 10% or more (alongside consideration of other qualitative factors), the modification is treated as substantial. Where the modification is substantial, the original financial liability is derecognised and a new financial liability is recognised at the fair value of the new terms, with any difference between the carrying amount of the extinguished liability and the fair value of the new liability recognised immediately in profit or loss as a gain or loss on extinguishment. Where the modification is not substantial, the original liability is not derecognised; instead, its carrying amount is recalculated as the present value of the renegotiated cash flows discounted at the original effective interest rate, with any resulting adjustment recognised immediately in profit or loss, and the effective interest rate is not reset, continuing to be based on the original rate applied to the revised cash flows going forward.

Question 13

A company transfers a portfolio of receivables to a third party, retaining an obligation to repurchase any receivable that becomes more than 60 days overdue, up to a capped amount. It has neither transferred nor retained substantially all the risks and rewards of ownership. Explain how derecognition should be assessed in this scenario.

Accepted Answer

Where an entity has neither transferred nor retained substantially all the risks and rewards of ownership of a financial asset, Ind AS 109 requires derecognition to be assessed based on whether control of the asset has been transferred to the transferee; if the transferee has the practical ability to sell the asset in its entirety to an unrelated third party without needing to impose additional restrictions, control has passed and the asset is derecognised, but if the entity's retained obligation, here the capped repurchase commitment for overdue receivables, means the transferee does not have this practical ability freely, control may not have fully passed. In this scenario, since the company retains an obligation (a form of continuing involvement) to repurchase overdue receivables up to a capped amount, and neither transfer nor retention of substantially all risks and rewards is complete, the assessment turns on control; if control genuinely has passed to the transferee for the portfolio as a whole, the company derecognises the receivables but continues to recognise an asset (and corresponding liability) to the extent of its continuing involvement — here, to the extent of its exposure under the capped repurchase obligation — rather than either fully derecognising the entire portfolio with no further recognition, or continuing to recognise the entire portfolio as though no transfer had occurred at all.

Question 14

A company hedges a forecast transaction using a forward contract, but the notional amount of the forward exceeds the quantity of the forecast transaction actually expected to occur, based on updated forecasts. Explain how the resulting hedge ineffectiveness should be treated.

Accepted Answer

Hedge ineffectiveness arises where the change in value of the hedging instrument does not exactly offset the change in value of the hedged item attributable to the hedged risk, and here, because the forward contract's notional amount exceeds the quantity of the forecast transaction genuinely expected to occur, the portion of the hedge relating to the excess notional does not correspond to any genuinely hedged exposure at all. Ind AS 109 requires the ineffective portion of the gain or loss on the hedging instrument, meaning the portion attributable to this excess, over-hedged notional amount, to be recognised immediately in profit or loss, rather than being included within the effective portion deferred in OCI under cash flow hedge accounting; only the portion of the hedging instrument's gain or loss that genuinely offsets the change attributable to the actual, updated quantity of the forecast transaction qualifies as the effective portion eligible for OCI treatment. This distinction matters because failing to separate out the ineffective, over-hedged portion would improperly defer a genuine profit or loss volatility into OCI that does not actually correspond to any real hedged exposure, undermining the very purpose hedge accounting's effectiveness requirement is meant to serve.

Question 15

A company designates a financial liability at fair value through profit or loss. During the year, the company's own credit rating deteriorates, causing the fair value of this liability to decrease due to the market pricing in higher credit risk. Explain where this specific component of the fair value change is recognised under Ind AS 109.

Accepted Answer

Ind AS 109 requires the amount of change in fair value of a financial liability designated at FVTPL that is attributable to changes in the entity's own credit risk to be presented in other comprehensive income, rather than in profit or loss, with the remaining amount of the change in fair value presented in profit or loss, unless this OCI treatment would create or enlarge an accounting mismatch, in which case the entire fair value change, including the own-credit-risk component, is recognised in profit or loss instead. This specific carve-out exists because recognising a gain in profit or loss purely because the entity's own creditworthiness has deteriorated, which is what a fall in the fair value of its own liability due to rising own credit risk would otherwise produce under a pure FVTPL model, is widely regarded as counterintuitive and potentially misleading to users — a company would appear to record improved profit or loss performance precisely because the market now perceives it as a worse credit risk, which most users would consider unrelated to genuine operating or financial performance, and Ind AS 109 specifically routes this component to OCI to avoid that counterintuitive outcome, absent an accounting mismatch concern.

Practice — Financial Instruments under Ind AS

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